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Portfolio Investing 101: Mel Lindauer

Mel Lindauer, Forbes columnist, book co-author, Boglehead extraordinaire, draws a road map for young investors in this installment of Portfolio Investing 101. Among his rules: start early, buy cheap if you can, automate your savings, and use your asset allocation to diversify your bets and manage your risk.

(Tomorrow we’ll have part 2 in which Lindauer takes on the challenges faced by investors closer to retirement and their options.)

Lindauer got into investing as a hobby. His full time job of 30 years was as the owner of a graphics arts firm in Philadelphia. But after a friend from college explained to him the concept of dollar cost averaging in the late 1960s, he got interested. His early experience wasn’t terribly positive. Lindauer got into an expensive investing contract, paying steep fees up front for no performance guarantee.

“I didn’t know anything at that point,” he recalls. “I was ripe for plucking and I got plucked.”

But he had caught the investing bug nonetheless and over time with plenty of self-study, he’s become an expert in personal investing.

A fan of Vanguard founder John Bogle’s low-cost approach to diversified investing, Lindauer teamed up with Taylor Larimore as moderators of the Boglehead investing forum and wiki for the past twelve years. Investors looking for some help sorting out their risk tolerance and investment choices can use the site’s 20,000 enthusiastic members as a sounding board. There is a lot of free information available there on the principals of smart investing as well. Lindauer and Larimore also teamed up, along with others, to co-author a pair of successful books on investing, The Bogleheads’ Guide to Investing and The Bogleheads’ Guide to Retirement Planning.

In a recent conversation with him from his home in Florida, Lindauer shared some of what he felt are the most important principles to remember when getting started as an investor.

Start Early. “I did start investing on a small scale at a young age. That’s one of the most important things I try to emphasize: the power of compounding. When you compare an investor who starts at 25 and invests $2000 a year for 10 years and never invests again for the rest of their life, and someone 35 who saves the same amount every year until 65, the person who started at 25 still has more money than the person who started at 35 when they both reach 65. When they’re young, most people are living for today. There are all the “toys” they feel they need to buy – but those are usually depreciating and worthless after a few years.”

This is a great market for young investors. “Young people should be praying for this kind of market. This is when they’re putting money in, and it’s on sale. Warren Buffet says be greedy when others are afraid. Do you believe the market will be better in 30 years? It’s basically a reflection of the US economy. If you don’t believe that then don’t buy. But people love to buy when the market is going great guns. You get in a taxi cab and the driver’s saying ‘I have a great tip for you’. Why would you want to buy when everything is high? We as consumers always love sales. If you love steak at $4 per pound, why wouldn’t you love it more at $3? When you buy the total stock market do you want to pay $100 for that or $50 or $20?”

Automate your savings as much as possible. “If you can automate your savings in a 401k or 403b, you never see the money. It automatically comes out.” That’s the most effective way to save. “With a 50% match it’s pretty hard to not come out ahead” even if you don’t have the best fund options to choose from.

Tune out the day-to-day market news and don’t chase performance. “There are only two days that matter, the day you buy and the day you sell. Everything in between is just noise.”

You’re going to have to do a little legwork. 401ks are good because they help people start saving at an early age. “But who traditionally is running the 401k? It’s Human Resources and they don’t know their ass from first base about investing. They’ve got a little manual, they pass it out. But people fresh out of college don’t know anything about investing, and a lot of the fund choices are overlapping. You might see 10 fund options and put 10% in each because you don’t have any guidance… You may end up with too much overlap or way too many bonds, say, for your risk tolerance.”

Starting is the most important thing. Asset allocation is the second most important thing. “Jack Bogle has a rule of thumb that your age in bonds is a good place to start.” [So a 30 year old would be 30% in bonds, 70% equity. A 60 year old, 60% bonds, 40% equity. ] “That assumes all investors have the same risk tolerance, which they don’t.” But some diversification is essential. “In the market in general some things zig while others zag. When you look at your total portfolio, your stocks may be down, but hopefully your bonds are up…The major determinant of your return and your portfolio’s volatility is going to be your asset allocation.”

Buy the market. There are mutual funds like the Vanguard Total Stock Market fund, that reflect the entire US market, and Vanguard International for foreign stocks or the FTSE World Fund for both domestic and foreign. Those are a great option for someone starting out in their 20s, Lindauer says. “Don’t try to pick and choose individual stocks. That’s traditionally a loser’s game. Over time owning the market through index funds will beat 80% of active funds. Active investors think they’re in Lake Woebegone. Everyone thinks they’re above average. It just doesn’t happen. There are always mutual funds that will be the market, but they’re not the same funds year after year.”

When buying bonds, think about inflation. “Mix your bonds. Buy something like Vanguard’s Total Bond Index, and then something like Vanguard’s TIPS fund, or buy individual TIPS.” {TIPS are inflation-protected bonds sold by the US Treasury that increase the principal at the rate of inflation (or decrease it by the rate of deflation). They also pay interest on that principal every six months at a fixed rate. . 10-year TIPS sold in July carried an interest rate of 1.25% ). ”The more inflation is a concern for you the more tilted you want to be toward inflation protection. We recommend 50/50 as neutral, 50% total bond market and 50% TIPS. A younger person’s future wages and wage increases will help to offset inflation. They may have 20% in tips or nothing in TIPS while an older person could be 100% in TIPS.”

Investing is an individual thing. You have to understand your risk tolerance and think about your time horizon. “Every person needs to balance their need for risk (in their investments) and their tolerance for risk. It’s really a problem when they have a need to take risk but not the tolerance. If that’s the case, they have to change things, either save more or work longer, or downsize. Someone else may accumulate enough assets at 40 or 45 or 50. They may not have the need to take risk. Even though they’re 50 and in theory the rule of thumb would be 50% bonds, 50% equity, they may choose to go to 80% in bonds.”

Think in dollars. “The possibility of losing 50% doesn’t mean a lot to people. But if you have a portfolio of $500,000 and you could potentially lose $250,000, then that’s much more meaningful.”

To examine Lindauer’s point about asset allocation, I did a very back-of-the-envelope analysis, using the price of the funds he mentioned and how they’ve moved over time, not adjusting for fees.

In short, the diversified portfolio Lindauer sketched out performs better than investing in the broader stock market alone.

If a 30 year old put $20,000 into the SPY S&P 500 ETF five years ago, that would today be worth $17,698. But putting 30% into bonds — half Vanguard Total Bond fund, half in Vanguard’s Inflation Protected Securities Fund– and splitting the rest between Vanguard Total Stock Market and Vanguard International, would have grown that $20,000 to $20,688 today. The reason: international stocks, bonds and TIPS all rose in that period, and were able to collectivley more than overcome the major droop in the Total Stock Market Fund.

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